Inflation and high interest rates continued to negatively impact hospital net income in 2023, forcing hospital systems to further assess their business portfolio for cost-saving opportunities. As a result, capabilities and facilities that were acquired by hospitals over the last 10 to 20 years to increase their service offerings—such as long-term care, home health, rehabilitation, nursing, hospice, diagnostic laboratories, and physician practices—are now being divested. These transactions typically involve either a full sale or the formation of a joint venture where a portion of the business is sold, both of which generate additional cash for the hospital to invest in other areas.
To make the best decision for their business, hospital leaders must understand an asset’s true value, which can only be accomplished by ensuring accurate supporting valuations and accounting for all expenses. Otherwise, hospitals risk entering a sale process with an inaccurate understanding of the value of their service line, potentially exacerbating their financial struggles.
Mistake One: Inaccurately Accounting for Overhead Expenses
To be compliant with Stark law and the Anti-Kickback Statute, the standard of value used in assessing a service line is fair market value (FMV). As such, a valuator must consider the service line as it would be operated as a stand-alone entity by a hypothetical buyer. This means all expenses must be fully considered, even if the hospital is currently operating the business in a way that does not directly account for the expense.
Overhead expenses encompass all management and staff costs required to operate the business; however, hospital financial business unit statements often only include costs related to direct staff (i.e., clinical support staff). Financial services, billing, management, strategy, accounting, marketing, human resources, IT and EHR system, and group purchasing staff expenses are usually not accounted for on the financial statements, providing a distorted view of the service line’s financials.
The most straightforward way to account for overhead expenses is through a management fee, which is generally charged as a percentage of revenue. This fee accounts for all management services that are being provided by either employed staff or a management company. Alternatively, the hospital can complete a full buildup of the expenses that considers the time each employee spends supporting the service line in their respective area.
Conversely, hospitals sometimes assign too much expense to the service line through overhead allocations, burdening the service line with overhead that would not be needed if it were a stand-alone entity. An adjustment should be made in these instances to reduce the expense, thereby potentially increasing the value of the service line.
Mistake Two: Underestimating Facility Costs
Another key aspect to consider in the valuation of a hospital-based business under FMV is the facility expense. This includes rent, utilities, repairs and maintenance, and any other cost associated with maintaining and operating the space. Rent is often expensed to a system-wide account, is not captured in business unit–level financials, and must be added to the valuation to reflect the hypothetical buyer-and-seller standard.
To properly estimate rent expense, hospitals may need to perform a market rent study—an analysis of the rental expense in the subject service area that considers the size and features of the actual space. This is most often needed in scenarios where the subject space is owned by the hospital and/or rent is not being charged at a level consistent with the market.
Another common area of misalignment occurs when hospitals operating home health businesses assume that the small space means there is no rent to be considered. In these cases, however, rent expense does need to be added to account for the facility used by the business’s administrative staff.
Mistake Three: Applying a Value to Downstream Revenue
Hospital-based businesses’ ability to bring additional patients into the health system’s core operations is one of the most important aspects of their financial value to the system. This revenue, referred to as downstream revenue, is generated at other health system units because of the original business line.
Because of downstream revenue, health systems may choose to operate certain businesses as loss leaders to generate profit elsewhere in the system. The revenue from other service areas, however, would not be available to a hypothetical buyer and so cannot be accounted for in a fair market valuation. Valuators can only consider the direct revenue generated by the service line.
Mistake Four: Accounting for Strategic Value
If a business is underperforming, the strategic value from the potential transaction cannot be considered to generate higher cash flow. The valuation firm would typically not use the income or market approaches in this instance and instead use the cost approach and value the assets on the balance sheet.
By its nature, the cost approach is less likely to result in significant value in the event of a sale, but that doesn’t mean those scenarios where it would be used are without benefit. Even in the absence of a significant up-front payment, hospitals may have strong rationale for selling an underperforming service line, such as enabling them to streamline operations, focus on core services, and eliminate losses.
Mistake Five: Valuing the Business on a Control Basis When a Minority Interest Is Sold
Often hospital-based businesses are contributed to a joint venture rather than simply sold. If the buyer will purchase a minority investment, this should be considered when determining the final value. The valuator needs to understand the operating terms to arrive at a final opinion, as those will influence the level of discount that should be applied to the value. A minority owner does not have control over the business decisions of the company (unless specific governance terms are added to the operating agreement) and thus will not value the ownership interest the same as the controlling entity.
Accurate Valuations Lead to Sustainable Futures
A complete, comprehensive view of a hospital’s service line is necessary to establish whether a potential divestiture makes strategic and financial sense for the health system. Once leaders correctly capture their hospital’s expenses, including overhead and rent, and remove the impact of downstream revenue, they can be certain they will have the most accurate picture of their non–core business’s performance.
This view, which will be reflected in the independent valuation firm’s opinion, will help leaders make informed decisions about how to handle underperforming service lines to support their goal of long-term success and sustained financial stability.
Edited by: Emily Johnson
This article was originally published in the American Health Law Association Journal in March 2024.
